Will the Fed's Latest Effort Mean a Smaller Rate Cut?

Reuters

Tuesday, 11 Mar 2008 | 1:49 PM ETReuters

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The Federal Reserve and other central banks teamed up to get hundreds of billions of dollars in fresh funds to cash-starved credit markets, allowing financial firms to use securities backed by home mortgages as collateral for central bank loans.

Stocks surged, bonds fell and the long-suffering U.S. dollar rose in reaction to the moves, a sign financial markets saw the plan as a viable remedy to ease a crisis that has threatened world economic growth.

Still, two questions emerged: will the Fed's latest action be enough to ease the credit crisis and will it mean a smaller interest-rate cut at next week's policy meeting?

In the latest effort to ease a credit contraction that has disrupted global finance, the Fed, Bank of Canada, Bank of England, European Central Bank and Swiss National Bank announced a series of aggressive measures to boost liquidity. It was the second time in three months that central banks from around the globe had launched coordinated efforts.

"In the near term, the Fed and global central banks have provided the thing everyone needed, and that's cash,'' said Martin Blum, head of emerging markets research at UniCredit in Vienna. "The actions ... deal with this issue by making it easier for banks to get cash, and that's important.''

The Fed expanded its securities lending program, offering up to $200 billion of highly-liquid U.S. Treasuries to primary dealers, secured for 28 days. It also significantly expanded the types of securities that can be used as collateral for loans. In effect, the plan allows banks to exchange unwanted mortgage notes for easy-to-sell government securities.

However, the U.S. central bank also said it would not accept private mortgage-backed securities that credit ratings agencies had put under review for possible downgrades.

That takes a bite out of the eligible debt, although the Fed said there may be as much as $1 trillion that would qualify for the auctions.

The Fed's moves came after some huge holders of mortgage-linked debt received demands for more cash as the value of the securities they held plunged. Investors, paralyzed by fears of a market shutdown, have shunned large sectors of the debt market, causing prices to tumble and leaving many offers for sales unfilled.

The Fed has shaved 2.25 percentage points from benchmark interest rates since mid-September in an effort to offset the impact of the credit tightening. Economists widely expect at least another half-point reduction when the Fed's policy-setting committee meets next week.

But Goldman Sachs economist Jan Hatzius said the latest steps from the Fed make a more aggressive cut less likely.

"This announcement makes clear that Fed officials are pulling out all the stops they can think of to deal with financial stress through the increased provision of liquidity into the system,'' he wrote in a note to clients. "To the extent they see this as substituting for rate cuts, this should reduce the probability of a 75 basis point rate cut next Tuesday.''

As part of the latest effort, the European Central Bank said it would auction up to $15 billion for a term of 28 days, the Swiss National Bank said it would auction $6 billion and the Bank of Canada said it would it provide about $4 billion.

Despite the positive market reaction, some analysts questioned whether the latest round of central bank efforts would have much staying power. Earlier efforts by the Fed and its counterparts were successful in reviving markets for a short time, only to see them unravel again when the next bout of credit turmoil emerged.

"This Fed action is good for a day or two,'' said Michael Cheah, senior portfolio manager at AIG SunAmerica Asset Management in Jersey City, New Jersey.

"There are three problems in the market. One is the price of money, then liquidity and counterparty risk. The Fed can do all it can in the first two areas by trying to reduce (interest rates) and the price of money. However, these moves are not going to mitigate the counterparty risk,'' he said.

Banks have essentially lost faith in each other after seven months of market unrest, making them reluctant to lend money to one another and driving up borrowing costs for the consumers and companies that power the world economy.

The Fed said its new lending facility will operate through weekly auctions that will start on March 27. It also said it was increasing existing currency swap lines with the ECB and SNB, allowing those two central banks to offer more U.S. dollars in their respective markets.

The U.S. Federal Reserve and other central banks teamed up to get hundreds of billions in fresh funds to cash-starved credit markets, allowing financial firms to use home mortgages as collateral.